Difference Between 401K and Pension

It is very important to save for the future; at the same time it is also very important to choose the retirement plan wisely so as to get the best benefit. There are many retirement plans that are popular in U.S., but here we would concentrate upon pension plan and 401k plan. Both of these have their distinct features, and pros and cons, and in this article, their differences will be highlighted. Both are good plans that are taken up by people to have a comfortable future after retirement.

401K

401k types are the most popular types of retirement plan available in U.S. today. It’s planned by the employer, though technically the contribution is by the employee. It is basically a saving for the future in which the employer holds back some part of the salary of the employee and uses it as a contribution towards a fund which the employee gets after retirement. This deduction is tax deferred, which is a benefit for anyone who opts for this plan. You can contribute up to $4000 per annum to your 401k fund, and the tax is deferred until you start receiving monthly payments upon retirement. In some instances, the employer matches the contributions by the employee with some money on his own every year. Both these contributions earn interest as per the prevalent rates.

Since 401k plans are very effective retirement plans that are capable of providing you the best shield in terms of financial security after retirement, the government and the employer would not encourage you to go for an interim withdrawal. That is why heavy tax penalties are inflicted on the person that wishes to go for early withdrawal in the 401k plan. You are eligible for withdrawal only if you are at least 59 ½ years old and if the fund is at least 5 years old. There is a 10% penalty imposed by the IRS if you withdraw the money before the age of 59 1/2.

You can still avoid the situation of paying harsh tax penalties in the event of early withdrawals from your 401k account provided you stick to certain strict withdrawal rules as far as a 401k account is concerned.

401k plans allow borrowing of loan against the vested account balance. You can borrow a loan up to 50% of the vested account balance. The maximum amount of loan should not exceed $50,000. The loan has to be of course repaid within a period of 5 years.

It is also possible to transfer your old 401k plan if you switch jobs, and if your new employer has 401k plan. There are several types of 401k plans and one can choose according to his needs.

Pension

Pension as a retirement plan has always been there. These form a fund for the employee which he gets upon his retirement. The major attraction of a pension plan is that the contribution to the fund is made by the employer. This contribution is often dependent upon the pay of the employee. There is no tax benefit to the employee every year as he is not making any contribution to the fund. Tax assessment is done upon disbursement which may be a lump sum or made through a series of payments every month.

Difference between 401k and Pension

Both 401k as well as pension are plans for retirement, and guarantee good financial health in old age. Pension plans have been there a long time now but 401k is gradually replacing pension everywhere in the United States. Pension is an old fashioned retirement plan where, without making any contribution, employee receives a predetermined amount every month. This amount is dependent upon the salary as well as the number of years of service.

On the other hand, contributions in a 401k are mostly made by the employee in the form of a percentage of his salary held back by the employer. This means that an employee has control over his investments in a 401k plan and he can choose to increase or decrease his contribution which is not possible in pension plan.

Another major difference between 401k and pension lies in the guarantee of payment. While in pension plan, an employer is more or less assured to receive a lump sum upon retirement, it is not so with a 401k. Here the amount he receives depends upon the contributions he has made periodically and the interest rate applicable at different times.

Recap:

While with pension plans, employees are assured of a monthly check every month upon retirement, it is not so with 401k.

Pension is totally sponsored by an employer, while 401k is sponsored by the employee.

Contribution is controlled by employees in 401k, while it is not so in pension plans.

401k plans allow borrowing of loan against the vested account balance

In conclusion, it can be said that pension plans, though attractive, allow no control by the employees, and as such are gradually getting replaced by 401k plans. At present, it is possible for an employee to participate in both the plans, if both the plans are available with the employer.

While the main benefit of any 401k plan is deferred tax, there are penalties if one needs withdrawal before the maturity of the plan. There are also difficulties of liquidity if someone needs money urgently.